'Passive' doesn't always mean 'index'

Strategic beta, quantitative and DFA funds prove that traditional indexing isn't the only passive method.

Adam Zoll 11 May, 2015 | 5:00PM

Question: Index funds are sometimes referred to as passive funds. Are they one and the same?

Answer: The terms "passive fund" and "index fund" are often used interchangeably, but they're not quite synonymous. In a nutshell, all index funds are passive, but not all passive funds are index funds, at least not in the traditional sense. So, what's the difference?

First, let's talk about what we mean when we use each of these terms. The term "index fund" is pretty straightforward. It refers to any fund, be it a traditional mutual fund or an exchange-traded fund, whose portfolio is managed so that it matches the holdings of a traditional index, such as the S&P/TSX 60 or the FTSE TMX Canada Universe Bond Index. The term "passive fund" is often used to differentiate funds from those that use active strategies--that is, in which a fund manager picks specific securities he or she thinks will help the fund outperform its benchmark. In a sense, a passive fund is one in which no active security selection is taking place. Rather, a system or formula is applied to manage the fund's portfolio.

Because index funds simply attempt to mirror an index and nothing more, they are considered passive funds. And since the vast majority of passive funds track traditional indexes, it's not uncommon to hear someone refer to passive funds when they mean traditional index funds, specifically. However, there are some funds that are, or may be considered, passively managed but aren't traditional index funds. They invest using carefully honed criteria or formulas without a human making portfolio decisions on each and every holding, yet they don't track a traditional index.

Such passive, non-traditional index funds come in a few different flavours based primarily on the systems they use to invest. Below are some examples.

DFA funds: In the United States, Dimensional Fund Advisors, also known as DFA, are among the best-known practitioners of the passive approach. The firm's Canadian line-up of funds is more modest, but like its U.S. offerings they are run using predetermined criteria based on the firm's extensive body of research. Rather than track commonly used indexes, DFA creates its own. Morningstar's fund analyst team describes DFA's process this way: "The firm's portfolio managers apply passive screens to emphasize securities with characteristics that have historically been associated with higher expected returns, including small market capitalizations and low valuations." (Morningstar's John Rekenthaler wrote about the rise of DFA and the blurring of the line between active and passive funds here.)

To cite one example, 3-star-rated DFA U.S. Core Equity is designed to capitalize on the premiums associated with value and small-cap investing (research shows that value stocks tend to outperform growth stocks, and that small-company stocks tend to outperform large-company stocks over long periods). The fund does this by underweighting the largest-capitalization U.S. stocks relative to the index, and emphasizing those that have higher-than-average book value relative to their market capitalization. Because it doesn't track an index, this strategy also means the fund trades on its own timetable rather than joining the crowd trying to buy stocks that are added to or sell those removed from a widely tracked index, thus avoiding overpaying for or underselling them. (One could argue that decisions such as these veer into the realm of active management, though the overall approach is generally passive.) Although DFA funds tend to charge low fees, they are available to retail investors only through financial advisors preselected by DFA.

Strategic beta funds: Approaches similar to those used by DFA have become increasingly popular in recent years but under a new name: strategic beta--sometimes called "smart beta." Strategic beta funds are designed to exploit certain market factors, such as value, momentum or volatility. And, like DFA funds, strategic beta funds track custom benchmarks designed to capture one or more of these factors. Here, again, funds are managed based on a given set of criteria but without tracking a traditional index.

Some argue that by overweighting certain factors, strategic beta funds are essentially applying active-management strategies but doing so through a formula or an algorithm, making them something of an active-index hybrid. After all, many active managers apply similar screens based on similar factors in order to identify securities that meet a given criteria. While traditional index funds are market-cap weighted, strategic beta funds often weight their holdings using some other method--such as by the degree to which their target factor is present. (Morningstar's Ben Johnson recently offered a primer on strategic beta funds, which you'll find here.)

Quantitative funds: Similar in nature to strategic beta funds, some funds use quantitative models to identify stocks with particular characteristics. The main difference is that the managers are constantly updating their research and from time to time will add or change factors in the models, and in some cases managers may override the formula and make an active call on whether to own a security. For example, RBC O'Shaughnessy Canadian Equity, a Canadian Focused Equity fund, updated its process following the financial crisis and now uses a quantitative, factor-based model that screens securities for attractive value, growth and quality characteristics, as well as high shareholder yield (dividends and share buybacks).

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Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com